First Keystone Financial, Inc. (the "Company") is a Pennsylvania corporation and the sole shareholder of First Keystone Bank, a federally chartered stock savings bank (the "Bank"), which converted to the stock form of organization in January 1995. The only significant assets of the Company are the capital stock of the Bank, the Company's loan to its employee stock ownership plan, and various equity and other investments. See Note 17 of the Notes to Consolidated Financial Statements for the fiscal year ended September 30, 2006 set forth in Item 8 hereof, "Financial Statements and Supplementary Data." The primary business of the Company consists of operating the Bank.
The Bank is a community oriented bank emphasizing customer service and convenience. The Bank's primary business is attracting deposits from the general public and using those funds together with other available sources of funds, primarily borrowings, to originate loans.
BUSINESS STRATEGY
Although the future growth of the Company and the Bank is restricted by the supervisory agreements described below, the Company intends to continue executing its strategy to transform itself from a traditional thrift into a locally-based community bank. The principal components of the Company's strategy include:
- Continuing expansion of product offerings. The Company intends to continue expanding the origination of commercial business loans and commercial and multi-family real estate loans while de-emphasizing the origination for portfolio of single-family residential loans. Commercial business and commercial and multi-family loans grew to $94.9 million, or 28.0% of the total loan portfolio, at September 30, 2006 compared to $72.3 million, or 23.9% of the total loan portfolio, at September 30, 2002. The Company has also expanded its presence in the land acquisition and construction loan market, increasing such loans to $38.2 million, or 11.3% of the total loan portfolio, at September 30, 2006 from $28.3 million, or 9.3% of the total loan portfolio, at September 30, 2002. The Bank in 2005 also introduced S Administration ("SBA") lending as an additional product choice for its customers, allowing the Bank to generate additional fee income. In 2006, the Bank was approved by the SBA under their Preferred Lender Program, which will allow the Bank to streamline the origination of SBA loans for its customers. To assist its commercial customers and to attract new business deposits, the Bank has created a Cash Management Division which provides extensive support services, including ACH activity, wire transfers, automated interest-earning clearing accounts and other cash management products. The Bank has also expanded its electronic delivery systems in recent years, including both commercial and retail bill paying services.
- Expanding commercial and construction lending infrastructure. In support of its expanded commercial business and commercial and multi-family real estate lending activities, the Bank has hired three additional employees with substantial commercial credit administration experience, increasing the Bank's commercial administration staff to five. The Bank plans to continue improving the integration of its business development officers and branch managers with the operations of its lending department. In addition, the Bank plans to hire additional experienced support personnel as well as commercial and construction lenders to increase the Bank's market penetration. The Bank's expanded commercial credit administration function is instrumental in developing and implementing more rigorous and extensive oversight of the Bank's commercial lending activities to, among other things, reduce the likelihood of credit quality issues.
- Increasing the amount of lower costing deposits. The Bank will continue to emphasize the generation of core deposits, in particular non-interest-bearing checking accounts, targeted to commercial customers, as well as developing account relationships with customers not traditionally focused on by the Bank, such as large non-profit organizations, municipalities and school districts. As of September 30, 2002, time deposits accounted for 53.3% of total deposits, while transaction, savings and MMDA accounts constituted 19.4%, 12.6% and 14.7% of total deposits, respectively. By contrast, as of September 30, 2006, the Company had reduced time deposits to 51.8% of total deposits, with low-cost transaction accounts increasing to 25.3% of total deposits and savings and MMDA accounts comprising 11.6% and 11.3%, respectively, of total deposits. With the recent rise in interest rates in 2006, the Bank, like many other financial institutions, has found customers moving funds to time deposits due to their generally higher rates. The Bank is currently developing remote deposit capabilities, which will enhance its ability to attract and retain commercial customers who are not located in close proximity to the branch network. The Bank expects to be able to commence offering its remote deposit product by the end of the second quarter of fiscal 2007. In tandem with the offering of the remote deposit product, the Bank expects to introduce its relationship banking product, which will reward customers for bundling services, allow more competitive pricing and target non-profit institutions and their constituents through affinity marketing programs.
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- Establishing branches in desirable locations. The Company seeks to open additional full-service branches in attractive suburban communities with growing populations and significant numbers of small and medium-sized businesses in Delaware and Chester Counties. The Bank opened its last branch office in Aston, Pennsylvania in October 2004, which, in less than 18 months, generated deposits of $21.3 million as of September 30, 2006. The Bank's goal is to open one new branch office approximately every 24 months, subject to the availability of attractive locations at reasonable prices and termination of the supervisory agreements.
- Maintaining customer service focus within a sales culture. To differentiate itself from its larger competitors, the Bank offers a high level of knowledgeable, personalized service to its customers. At the same time, the Bank emphasizes a sales culture with a focus on cross-selling the many different types of products it offers. In November 2005, the Bank completed an 18-month customer training program for all its employees designed to improve and enhance the Bank's ability to meet its customers' increasingly complex and diverse needs, especially those of its business customers. The Bank has also hired two experienced business development officers who are primarily responsible for attracting new business and expanding current bank relationships. These business development officers interface with the branch network and commercial lenders to facilitate and expand banking relationships and increase customer satisfaction and loyalty.
MARKET AREA AND COMPETITION
The Bank's primary market area is Delaware and Chester Counties, which are located in the southeastern corner of Pennsylvania between two prominent metropolitan areas - Philadelphia, Pennsylvania and Wilmington, Delaware. There is easy access to I-95, the Philadelphia International Airport and the Delaware River, and the Bank is fortunate to be located in such a desirable geographic area. New York City is just 92 miles away from the Bank's headquarters in Media, Pennsylvania, while Baltimore, Maryland and Washington, DC are only 80 miles and 127 miles away, respectively.
Through an extensive highway network, the economies of Delaware and Chester Counties are knitted tightly into a regional economy of more than 2.5 million workers. Delaware and Chester Counties have a large, well-educated, and skilled labor force, with nearly one quarter of the counties' population having earned a four-year college degree. The median household income of Delaware and Chester Counties in 2005 was approximately $62,380 and $81,000, respectively, as compared to approximately $48,500 for Pennsylvania as a whole. In addition, Philadelphia's central location in the Northeast corridor, infrastructure, and other factors have made the Bank's primary market area attractive to many large corporate employers, including Comcast, Boeing, State Farm Insurance, United Parcel Service, PECO Energy, SAP America, Inc. and Wawa.
The Philadelphia area economy is typical of many large northeastern cities where the traditional manufacturing-based economy has declined and been replaced by the service sector, including the health care market. Crozer/Keystone Health System, Mercy Health Corp., and Astra-Zeneca are among the larger health care employers within the Bank's market area. According to the Delaware County Chamber of Commerce, there is more than 65 degree-granting institutions in the Delaware Valley region, representing a higher density of colleges and universities than any other area in the United States. Delaware County also has one of the nation's lowest unemployment rates and one of the most active Chamber of Commerce Offices in the Commonwealth. In fact, the Delaware County Chamber of Commerce has been recognized by the U.S. S Administration (Philadelphia District Office) for its accomplishments several times within the past few years.
The population of Delaware County is reported at over half a million residents and is the fifth most populated county in the Commonwealth of Pennsylvania. Much of the growth and development continues to be in the western part of the county and adjacent Chester County. In the second calendar quarter of 2006, unemployment in Chester County was extremely low - at 3.6% - compared to the rest of the Commonwealth, which was at an average of 5.0%. The Bank continues to benefit from this growth as its Chester Heights branch, situated in a prime location in Western Delaware County, has exceeded the Company's deposit and consumer loan projections year after year. Chester County's growth rate is expected to increase even further in the next decade, and some of the communities in Chester County that are experiencing the most rapid growth - East Marlborough Township, New Garden Township and East Goshen - surround the Bank's Chester County branch.
The Bank experiences strong competition for real estate loans, principally from other savings associations, commercial banks, and mortgage-banking companies. The Bank competes for these and other loans primarily through the interest rates and loan fees it charges, the efficiency and quality of the services it provides borrowers, and the convenient locations of its branch office network.
The Bank faces strong competition both in attracting deposits and making real estate and commercial loans. Its most direct competition for deposits has historically come from other savings associations, credit unions, and commercial banks located in its market area. This includes many large regional financial institutions which have even greater financial and marketing resources available to them. The ability of the Bank to attract and retain core deposits depends on its ability to provide a competitive rate of return, liquidity, and service convenience comparable to those offered by competing investment opportunities. The Bank's management remains focused on attracting core deposits through its branch network, business development efforts, and commercial business relationships. The Business Development Team works closely with and strongly supports the efforts of the branches, in addition to redesigning more competitive business packages as well as provides SBA lending services to enhance s deposit products.
The Bank maintains seven branch offices in Delaware County with deposits totaling $358.8 million at September 30, 2006 and one branch office in Chester County with deposits totaling $19.9 million at September 30, 2006. Based on deposits as of June 30, 2006 (the most recent data used by the FDIC), the Bank's market share in Delaware and Chester Counties was 3.4% and 0.7%, respectively. The Bank believes it has the opportunity to expand its deposit market share in the future.
SUPERVISORY AGREEMENTS
On February 13, 2006, the Company and the Bank each entered into supervisory agreements with the OTS. The Company and the Bank were required to enter into these agreements primarily to address issues identified in the OTS' report of examination issued in 2005 regarding the Company's and the Bank's operations and financial condition.
Under the terms of the supervisory agreement between the Company and the OTS, the Company agreed to, among other things, (i) develop and implement a three-year capital plan designed to support the Company's efforts to maintain prudent levels of capital and to reduce its debt-to-equity ratio below 50%; (ii) not incur any additional debt without the prior written approval of the OTS; and (iii) not repurchase any shares of or pay any cash dividends on its common stock until the Company complied with certain conditions. Upon reducing its debt-to-equity below 50%, the Company may resume the payment of quarterly cash dividends at the lesser of the dividend rate in effect immediately prior to entering into the supervisory agreement ($0.11 per share) or 35% of its consolidated net income (on an annualized basis), provided that the OTS, upon review of prior notice from the Company of the proposed dividend, does not object to payment.
Under the terms of the supervisory agreement between the Bank and the OTS, the Bank agreed to, among other things, (i) not grow in any quarter in excess of the greater of 3% of total assets (on an annualized basis) or net interest credited on deposit liabilities during such quarter; (ii) maintain its core capital and total risk-based capital in excess of 7.5% and 12.5%, respectively; (iii) adopt revised policies and procedures governing commercial lending; (iv) conduct periodic reviews of its commercial loan department; (v) conduct periodic internal loan reviews; (vi) adopt a revised asset classification policy; and (vii) not amend compensatory arrangements with senior executive officers and directors, subject to certain exceptions, without the prior approval of the OTS. As a result of the growth restriction imposed on the Bank, the Company's growth is currently and will continue to be substantially constrained unless and until the supervisory agreements are terminated or modified. As of March 31, 2006 and June 30, 2006, the Bank exceeded the growth limitation contained in the supervisory agreement with the OTS described above. Subsequent to June 30, 2006, the Bank reduced its assets sufficiently to be below the June 30, 2006 limitation. The OTS advised the Bank that it will not take any regulatory action against the Bank provided it will be in compliance with the growth limitation as of September 30, 2006. The Bank complied with the growth restriction at September 30, 2006.
The Company recently underwent an examination by the OTS. In connection with such examination, the OTS reviewed the Company's and the Bank's compliance with the provisions of the supervisory agreements. Although the Company and the Bank were determined to be in full or partial compliance with substantially all of the provisions of the supervisory agreements, the examination did note a number of areas for improvement with respect to the Bank's loan underwriting, credit analysis and asset classification policies and procedures. In order to strengthen these areas, the Bank intends to hire a Chief Credit Officer. The Bank is aggressively addressing these areas for improvement in its lending
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operations to be able to be in full compliance with the terms of the supervisory agreements as soon as possible. Except as described above, the Company believes it and the Bank are in material compliance with the supervisory agreements.
The Company has submitted to and received from the OTS approval of a capital plan, which plan calls for an equity infusion in order to reduce the Company's debt-to-equity ratio below 50%. As part of its capital plan, the Company conducted a private placement of 400,000 shares of common stock, raising gross proceeds of approximately $6.5 million. The net proceeds of approximately $5.8 million will be used to reduce the amount of its outstanding trust preferred securities. The Company intends to use all of the net proceeds to redeem approximately $5.8 million of its trust preferred securities in June 2007. As a result of such redemption, the Company's debt-to-equity ratio will be less than 50%. The Company believes it will be able to resume paying quarterly cash dividends in the quarter ending September 30, 2007. However, no assurances can be given that the Company will satisfy the conditions necessary to resume paying dividends or that the OTS will not object to the resumption of dividends or, if resumed, that the Company will be able to pay dividends at the same rate that it has historically paid or be able to continue to pay dividends. The Company and the Bank will make every effort to have both supervisory agreements terminated or the operating restrictions substantially reduced by the end of fiscal year 2007. However, no assurances can be given that either of such events will occur.
Although the growth limitations imposed by the supervisory agreements constrain the Bank's ability to implement certain aspects of its business strategy, the Bank will continue to pursue its transition from a traditional residential lender to a community bank. While the supervisory agreements are in effect, the Bank intends to continue:
- emphasizing higher yielding assets, such as commercial business and real estate loans, as well as further developing fee income and other forms of non-interest income;
- developing relational deposits, in particular non-interest-bearing checking accounts, with its commercial customers;
- aggressively reviewing and managing its cost structure in order to improve its financial performance; and
- enhancing its electronic delivery systems, in particular remote banking, which will enable business customers to expedite check processing, thereby allowing commercial customers faster access to their funds as well as improved cash flow management.
Following the termination or substantive revision of the operating restrictions in the supervisory agreements, the Company intends to expand its commercial business and real estate loan portfolio and to continue expanding its branch network and diversifying its funding sources.
LENDING ACTIVITIES
Loan Portfolio Composition. The following table sets forth the composition of the Bank's loan portfolio by type of loan at the dates indicated (excluding loans held for sale).
---------- (1) Consists primarily of credit card loans.
(2) Does not include $1.3 million, $41,000, $172,000, $4.5 million and $501,000 of loans held for sale at September 30, 2006, 2005, 2004, 2003 and 2002, respectively.
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Contractual Principal Repayments. The following table sets forth the scheduled contractual maturities of the Bank's loans held to maturity at September 30, 2006. Demand loans, loans having no stated schedule of repayments and no stated maturity and overdraft loans are reported as due in one year or less. The amounts shown for each period do not take into account loan prepayments and normal amortization of the Bank's loan portfolio held to maturity.
---------- (1) Includes home equity loans and lines of credit.
(2) Does not include adjustments relating to loans in process, allowances for loan losses and deferred fee income and discounts.
Scheduled contractual amortization of loans does not reflect the expected term of the Bank's loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses which give the Bank the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when current mortgage loan rates are lower than rates on existing mortgage loans, due to refinancings of adjustable-rate and fixed-rate loans at lower rates. Under the latter circumstances, the weighted average yield on loans decreases as higher yielding loans are repaid or refinanced at lower rates.
Loan Origination, Purchase and Sale Activity. The following table shows the loan origination, purchase and sale activity of the Bank during the periods indicated.
---------- (1) Includes loans held for sale of $1.3 million, $41,000 and $172,000 at September 30, 2006, 2005 and 2004, respectively.
The residential lending activities of the Bank are subject to written underwriting standards and loan origination procedures established by the Bank's Board of Directors and management. Loan applications may be taken at all of the Bank's branch offices by the branch manager or other designated loan officers. Applications for single-family residential mortgage loans for portfolio retention are obtained predominately through loan originators who are employees of the Bank. The Bank's residential loan originators will take loan applications outside of the Bank's offices at the customer's convenience and are compensated on a commission basis. The Residential Lending Department supervises the process of obtaining credit reports, appraisals and other documentation involved with the origination of a loan. In most cases, the Bank requires that a property appraisal be obtained in connection with all new first mortgage loans. Generally, appraisals are not required on home equity loans below $250,000 because alternative means of valuation are used (i.e., tax assessments, home value estimators). Property appraisals generally are performed by an independent appraiser selected from a list approved by the Bank's Board of Directors. The Bank requires that title insurance (other than with respect to home equity loans) and hazard insurance be maintained on all security properties and that flood insurance be maintained if the property is within a designated flood plain.
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Residential mortgage loan applications are primarily developed from referrals from real estate brokers and builders, existing customers and walk-in customers. Commercial and multi-family real estate loan applications are obtained primarily from previous borrowers, direct solicitations by Bank personnel, as well as referrals. Consumer loans originated by the Bank are obtained primarily through existing and walk-in customers who have been made aware of the Bank's programs by advertising and other means.
Applications for single-family residential mortgage loans which may be originated for resale in the secondary market or loans designated for portfolio retention that conform to the requirements for resale into the secondary market and do not exceed Fannie Mae ("FNMA") or Freddie Mac ("FHLMC") limits are approved by at least one of the following: the Bank's Director of Lending, the Senior Mortgage Loan Underwriter or the Loan Committee (a committee comprised of four directors and the Director of Lending). Residential mortgage loans in excess of FNMA/FHLMC maximum amounts (currently $417,000 for single-family properties) but less than $1.0 million must be approved by the Loan Committee. Commercial and multi-family residential real estate mortgage loans in excess of $250,000 and all construction loans must be approved by the Loan Committee. All mortgage loans in excess of $1.0 million must be approved by the Bank's Board of Directors or the Executive Committee thereof. All mortgage loans which do not require approval by the Board of Directors are submitted to the Board at its next meeting for review and ratification. Home equity loans and lines of credit up to $250,000 can be approved by the Director of Lending, the Vice President of Construction Loans, the Vice President of Residential Lending or the Senior Mortgage Loan Underwriter. Loans in excess of such amount must be approved by the Loan Committee.
Single-Family Residential Loans. Substantially all of the Bank's single-family residential mortgage loans consist of conventional loans. Conventional loans are loans that are neither insured by the Federal Housing Administration nor partially guaranteed by the Department of Veterans Affairs. The vast majority of the Bank's single-family residential mortgage loans are secured by properties located in Pennsylvania, primarily in Delaware and Chester Counties, and are originated under terms and documentation which permit their sale to FHLMC or FNMA. During fiscal 2006, due to the inverted yield curve, continuing interest rate margin compression, and the unappealing spreads on mortgage-backed securities, the Bank decided to retain $13.8 million of its newly originated 30-year term fixed-rate residential mortgage loans in its portfolio. The Bank will continue to retain its adjustable-rate mortgage loans and shorter term fixed-rate residential mortgage loans. See "- Mortgage-Banking Activities."
The single-family residential mortgage loans offered by the Bank currently consist of fixed-rate loans, including bi-weekly and balloon loans and adjustable-rate loans. Fixed-rate loans generally have maturities ranging from 15 to 30 years and are fully amortized with monthly loan payments sufficient to repay the total amount of the loan with interest by the end of the loan term. The Bank's fixed-rate loans are originated under terms, conditions and documentation which permit them to be sold to U.S. Government-sponsored agencies, such as FHLMC or FNMA, and other purchasers in the secondary mortgage market. The Bank also offers bi-weekly loans under the terms of which the borrower makes payments every two weeks. Although such loans have a 30-year amortization schedule, due to the bi-weekly payment schedule, such loans repay substantially more rapidly than a standard monthly amortizing 30-year fixed-rate loan. The Bank also offers five and seven year balloon loans which provide that the borrower can conditionally renew the loan at the fifth or seventh year at a then to-be-determined interest rate for the remaining 25 or 23 years, respectively, of the amortization period. At September 30, 2006, $127.7 million, or 88.3% of the Bank's single-family residential mortgage loans held in portfolio were fixed-rate loans, including $7.9 million of bi-weekly, fixed-rate residential mortgage loans.
The adjustable-rate loans currently offered by the Bank have interest rates which adjust every one, three or five years in accordance with a designated index, such as U.S. Treasury obligations, adjusted to a constant maturity ("CMT"), plus a stipulated margin. The Bank's adjustable-rate single-family residential real estate loans generally have a cap of 2% on any increase or decrease in the interest rate at any adjustment date, and a maximum adjustment limit of 6% on any such increase or decrease over the life of the loan. In order to increase the originations of adjustable-rate loans, the Bank has been originating loans which bear a fixed interest rate for a period of three to five years after which they convert to one-year adjustable-rate loans. The Bank's adjustable-rate loans require that any payment adjustment resulting from a change in the interest rate of an adjustable-rate loan be sufficient to result in full amortization of the loan by the end of the loan term and, thus, do not permit any of the increased payment to be added to the principal amount of the loan, creating negative amortization. Although the Bank does offer adjustable-rate loans with initial rates below the fully indexed rate, loans tied to the one-year CMT are underwritten using methods approved by FHLMC or FNMA which require borrowers to be qualified at 2% above the discounted loan rate under certain conditions. The Bank has taken steps to increase the amount of such loans originated in recent years, but with limited interest by consumers due to the
low interest rate environment that existed prior to fiscal 2006. At September 30, 2006, $16.9 million, or 11.7%, of the Bank's single-family residential mortgage loans held for portfolio were adjustable-rate loans.
Adjustable-rate loans decrease the risks associated with changes in interest rates but involve other risks. In the event interest rates increase, the loan payment by the borrower also increases to the extent permitted by the terms of the loan, thereby increasing the potential for default. In addition, adjustable-rate loans tend to prepay and convert to fixed rates when the overall interest rate environment is low. Moreover, as with fixed-rate loans, as interest rates increase, the marketability of the underlying collateral property may be adversely affected by higher interest rates. The Bank believes that these risks, which have not had a material adverse effect on the Bank to date, generally are less than the risks associated with holding fixed-rate loans in an increasing interest rate environment.
For conventional residential mortgage loans held in portfolio and also for those loans originated for sale in the secondary market, the Bank's maximum loan-to-value ("LTV") ratio is 97%, and is based on the lesser of sales price or appraised value. On loans with a LTV ratio of over 80%, private mortgage insurance may be required to be obtained or the Bank, on occasion, may lend the excess as a home equity loan.
Commercial and Multi-Family Residential Real Estate Loans. During fiscal 2006, the Bank slightly increased its investment in commercial and multi-family residential loans. Such loans are being made primarily to small- and medium-sized businesses located in the Bank's primary market area, a segment of the market that the Bank believes has continued to be underserved in recent years. Loans secured by commercial and multi-family residential real estate amounted to $70.4 million, or 20.8%, of the Bank's total loan portfolio, at September 30, 2006. The Bank's commercial and multi-family residential real estate loans are secured primarily by professional office buildings, small retail establishments, warehouses and apartment buildings (with 36 units or less) located in the Bank's primary market area.
The Bank's adjustable-rate multi-family residential and commercial real estate loans generally are either three or five-year adjustable-rate loans indexed to the CMT plus a margin. In addition, depending on collateral value and strength of the borrower, fixed-rate balloon loans and longer term fixed-rate loans may be originated. Generally, fees of up to 1% of the principal loan balance are charged to the borrower upon closing. Although terms for multi-family residential and commercial real estate loans may vary, the Bank's underwriting standards generally provide for terms of up to 20 years with amortization of the principal over the term of the loan and LTV ratios of not more than 75%. Generally, the Bank obtains personal guarantees of the principals of the borrower as additional security for any commercial real estate and multi-family residential loans and requires that the borrower have at least a 25% equity investment in any such property.
The Bank evaluates various aspects of commercial and multi-family residential real estate loan transactions in an effort to mitigate risk to the extent possible. In underwriting these loans, consideration is given to the stability of the property's cash flow history, future operating projections, current and projected occupancy, position in the market, location and physical condition. In recent periods, the Bank has generally imposed a debt coverage ratio (the ratio of net cash from operations before payment of debt service to debt service) of not less than 110%. The underwriting analysis also includes credit checks and a review of the financial condition of the borrower and guarantor, if applicable. An appraisal report is prepared by a state-licensed and certified appraiser (generally an appraiser who is qualified as a Member of the Appraisal Institute ("MAI")) commissioned by the Bank to substantiate property values for every commercial real estate and multi-family loan transaction. All appraisal reports are reviewed by the commercial loan underwriter prior to the closing of the loan.
Multi-family residential and commercial real estate lending entails different and significant risks when compared to single-family residential lending because such loans often involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower's business. These risks also can be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses or other commercial space. The Bank attempts to minimize its risk exposure by limiting such lending to proven owners, only considering properties with existing operating performance which can be analyzed, requiring conservative debt coverage ratios, and periodically monitoring the operation and physical condition of the collateral. See "-Asset Quality - Non-performing Assets" for further discussion of the Bank's non-performing loans.
Construction Loans. Substantially all of the Bank's construction loans consist of loans for acquisition and development of properties to construct single-family properties extended either to individuals or to selected developers with whom the Bank is familiar to build such properties on a pre-sold or limited speculative basis.
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To a lesser extent, the Bank provides financing for construction to permanent commercial real estate properties. Commercial construction loans have a maximum term of 24 months during the construction period with interest based upon the prime rate published in the Wall Street Journal ("Prime Rate") plus a margin and have LTV ratios of 80% or less of the appraised value of the project upon completion. The loans convert to permanent commercial real estate loans upon completion of construction. With respect to construction loans to individuals, such loans have a maximum term of 12 months, have variable rates of interest based upon the Prime Rate plus a margin and have LTV ratios of 80% or less of the appraised value of the property upon completion and generally do not require the amortization of principal during the term. Upon completion of construction, the borrower is required to refinance the loan although the Bank may be the lender of the permanent loan secured by the property.
The Bank also provides construction loans (including acquisition and development loans) and revolving lines of credit to developers. The majority of construction loans consists of loans to selected local developers with whom the Bank is familiar and who build single-family dwellings on a pre-sold or, to a significantly lesser extent, on a speculative basis. The Bank generally limits to two the number of unsold units that a developer may have under construction in a project. Such loans generally have terms of 36 months or less, generally have a maximum LTV ratio of 75% of the appraised value of the property upon completion and do not require the amortization of the principal during the term. The loans are made with variable rates of interest based on the Prime Rate plus a margin adjusted on a monthly basis. The Bank also receives origination fees that generally range from 0.5% to 3.0% of the amount of the loan commitment. The borrower is required to fund a portion of the project's costs, the exact amount being determined on a case-by-case basis but usually not less than 25%. Loan proceeds are disbursed by percentage of completion of the cost of the project after inspections indicate that such disbursements are for costs already incurred and which have added to the value of the project. Only interest payments are due during the construction phase and the Bank may provide the borrower with an interest reserve from which it can pay the stated interest due thereon.
At September 30, 2006, residential construction loans totaled $18.5 million, or 5.5%, of the total loan portfolio, primarily consisting of construction loans to developers. At September 30, 2006, commercial construction loans totaled $967,000, or 0.29%, of the total loan portfolio.
The Bank also originates ground or land loans to individuals to purchase a property on which they intend to build their primary residences, as well as to developers to purchase lots to build speculative homes at a later date. Such loans have terms of 36 months or less with a maximum LTV ratio of 75% of the lower of appraised value or sale price. The loans are made with variable rates based on the Prime Rate plus a margin. The Bank also receives origination fees, which generally range between 1.0% and 3.0% of the loan amount. At September 30, 2006, land loans (including loans to acquire and develop land) totaled $18.7 million, or 5.5%, of the total loan portfolio.
Loans to developers include both secured and unsecured lines of credit (which are classified as commercial business loans) with outstanding commitments totaling $730,000. All have personal guarantees of the principals and are cross-collateralized with existing loans. At September 30, 2006, loans outstanding under builder lines of credit totaled $500,000, all of which was unsecured. Such loans are only given to the Bank's most creditworthy long standing customers.
Prior to making a commitment to fund a construction loan, the Bank requires an appraisal of the property by an appraiser approved by the Board of Directors. In addition, during the term of the construction loan, the project is inspected by an independent inspector.
Construction financing generally is considered to involve a higher degree of risk of loss than long-term financing on improved, owner-occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of value proves to be inaccurate, the Bank may be confronted, at or prior to the maturity of the loan, with a project, when completed, having a value which is insufficient to assure full repayment. Loans on lots may run the risk of adverse zoning changes as well as environmental or other restrictions on future use.
Home Equity Loans and Lines of Credit. Home equity loans and home equity lines of credit are secured by the underlying equity in the borrower's primary residence or, occasionally, other types of real estate. Home equity loans are amortizing loans with fixed interest rates with a maximum term of 15 years while equity lines of credit have adjustable interest rates indexed to the Prime Rate with a term of 10 years and interest-only payments. Generally home equity loans or home equity lines of credit do not exceed $100,000. The Bank's home equity loans and lines of credit generally require combined LTV ratios of 80% or less. Loans with higher LTV ratios are available but with higher interest rates and stricter credit standards. At September 30, 2006, home equity loans and lines of credit amounted to $59.3 million, or 17.5%, of the Bank's total loan portfolio.
Commercial Business Loans. The Bank has also emphasized in recent periods the growth of its commercial business loan portfolio by granting such loans directly to business enterprises that are located in its market area. The majority of such loans are for less than $1.0 million. The Bank actively targets and markets this product to small-and medium-sized businesses. Applications for commercial business loans are obtained from existing commercial customers, branch and customer referrals, direct inquiry and those that are obtained by our commercial lending officers. As of September 30, 2006, commercial business loans amounted to $24.5 million, or 7.2%, of the Bank's total loan portfolio. The commercial business loans consist of a limited number of commercial lines of credit secured by equipment and securities, some working capital financings secured by accounts receivable and inventory and, to a limited extent, unsecured lines of credit. Commercial business loans originated by the Bank ordinarily have terms of five years or less and fixed rates or adjustable rates tied to the Prime Rate plus a margin.
Although commercial business loans generally are considered to involve greater credit risk than certain other types of loans, management intends to continue to offer commercial business loans to small- and medium-sized businesses in an effort to better serve our community's needs, obtain core non-interest-bearing deposits and increase the Bank's interest rate spread and improve interest rate sensitivity. See " -Asset Quality" for discussion of the Bank's non-performing and classified assets.
In the latter part of fiscal 2005, the Bank began to market loans guaranteed by the S Administration. During fiscal 2006, the Bank was approved as an SBA Preferred Lender. As an SBA Preferred Lender, the Bank has earned the privilege of approving SBA Loans without requesting the approval of the SBA prior to closing the loan. All SBA policies and procedures must be followed by the Bank to maintain its Preferred Lender Status. As part of the Company's asset liability strategy, the Bank intends to sell the guaranteed portion of the loan upon loan settlement. In fiscal 2006, the Bank recognized $132,000 from the sale of SBA loans compared to $0 in 2005. Such experience will continue to be leveraged to grow this business line.
Consumer Lending Activities. The Bank also offers a variety of consumer loans in order to provide a full range of retail financial services to its customers. At September 30, 2006, $1.4 million, or 0.41%, of the Bank's total loan portfolio was comprised of consumer loans. The Bank originates substantially all of such loans in its market area. At September 30, 2006, the Bank's consumer loan portfolio was comprised of credit card, deposit, automobile, unsecured personal loans and other consumer loans. The Bank's credit card program is primarily offered to only the Bank's most creditworthy customers. At September 30, 2006, these loans totaled $652,000, or 0.19%, of the total loan portfolio. Another component of the consumer loan portfolio is unsecured loans amounting to $538,000, or 0.16%, of the Bank's loan portfolio at September 30, 2006.
Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral and, in certain cases, the absence of collateral.
Mortgage-Banking Activities. Due to customer preference for fixed-rate loans, the Bank has continued to originate fixed-rate loans. Long-term (generally 30 years) fixed-rate loans not taken into portfolio for asset/liability purposes are sold into the secondary market. The Bank's net gain on sales of single-family residential loans amounted to $24,000, $93,000 and $54,000 during the fiscal years ended September 30, 2006, 2005 and 2004, respectively. The decrease in net gain on sales for mortgage loans in fiscal 2006 was a result from the Bank's decision to retain 30-year single-family residential loans into its loan portfolio as part of the Bank's asset/liability strategy. Gains on sales of loans held for sale slightly increased in fiscal 2005; however, the Bank continued to experience a slowdown in 2006 in the refinancing market in 30-year residential loans. The Bank did not have any single-family residential loans held for sale at September 30, 2006 and 2005.
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The Bank's conforming mortgage loans sold to others are sold, generally with servicing retained, on a loan-by-loan basis primarily to FHLMC or FNMA. A period of less than five days generally elapses between the closing of the loan by the Bank and its purchase by the investor. Mortgages with established interest rates generally will decrease in value during periods of increasing interest rates. Accordingly, fluctuations in prevailing interest rates may result in a gain or loss to the Bank as a result of adjustments to the carrying value of loans held for sale or upon sale of loans. The Bank attempts to protect itself from these market fluctuations through the use of forward commitments entered into at the same time of the commitment by the Bank of a loan rate to the borrower. These commitments are mandatory delivery contracts with the purchaser, generally FHLMC or FNMA, within a certain time frame and within certain dollar amounts by a price determined at the commitment date. Market risk does exist as non-refundable points paid by the borrower may not be sufficient to offset fees associated with closing the forward commitment contract.
Loan Origination Fees and Servicing. Borrowers may be charged an origination fee, which is a percentage of the principal balance of the loan. In accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," the various fees, net of costs, received by the Bank in connection with the origination of loans are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. However, when such loans are sold, the remaining unamortized fees (which is all or substantially all of such fees due to the relatively short period during which such loans are held) are recognized as income on the sale of loans held for sale.
The Bank, for conforming loan products, generally retains the servicing on all loans sold to others. In addition, the Bank services substantially all of the loans that it retains in its portfolio. Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, making advances to cover delinquent payments, making inspections as required of mortgaged premises, contacting delinquent mortgagors, supervising foreclosures and property dispositions in the event of unremedied defaults and generally administering the loans. Funds that have been escrowed by borrowers for the payment of mortgage-related expenses, such as property taxes and hazard and mortgage insurance premiums, are maintained in non-interest-bearing accounts at the Bank.
The following table presents information regarding the loans serviced by the Bank for others at the dates indicated. Substantially all the loans were secured by properties in Pennsylvania. A small percentage of the loans are secured by properties located in Delaware, Maryland or New Jersey.
The Bank receives fees for servicing mortgage loans, which generally amount to 0.25% per annum on the declining principal balance of mortgage loans. Such fees serve to compensate the Bank for the costs of performing the servicing function. Other sources of loan servicing revenues include late charges. The Bank retains a portion of funds received from borrowers on the loans it services for others in payment of its servicing fees received on loans serviced for others. For fiscal years ended September 30, 2006, 2005 and 2004, the Bank earned gross fees of $139,000, $133,000 and $132,000, respectively, from loan servicing.
Loans-to-One Borrower Limitations. Regulations impose limitations on the aggregate amount of loans that a savings institution could make to any one borrower, including related entities. Under such regulations, the permissible amount of loans-to-one borrower follows the national bank standard for all loans made by savings institutions, which generally does not permit loans-to-one borrower to exceed 15% of unimpaired capital and surplus. Loans in an amount equal to an additional 10% of unimpaired capital and surplus also may be made to a borrower if the loans are fully secured by readily marketable securities. At September 30, 2006, the Bank's five largest loans or groups of loans-to-one borrower, including related entities, ranged from an aggregate of $4.0 million to $6.6 million. The Bank's loans-to-one borrower limit was $7.5 million at such date.
ASSET QUALITY
General. As a part of the Bank's ongoing efforts to improve its asset quality, it has developed and implemented an asset classification system. All of the Bank's assets are subject to review under the classification system, but particular emphasis is placed on the review of multi-family residential and commercial real estate loans, construction loans and commercial business loans. All assets of the Bank are periodically reviewed and the classification recommendations submitted to the Asset Quality Review Committee. The Asset Quality Review Committee is composed of the President and Chief Executive Officer, the Chief Financial Officer, the Director of Lending, the Vice President of Loan Administration, the Internal Auditor and the Vice President of Construction Lending and meets at least monthly. All assets are placed into one of the five following categories: pass, special mention, substandard, doubtful and loss. During fiscal 2006, a rating system was created and implemented grading assets as follows: 1-6 as pass, 7 as special mention and 8, 9 and 10 as an adverse classification (substandard, doubtful and loss, respectively). Loans classified as "pass" are then placed into one of the six grades based on objective criteria of credit underwriting. See "- Non-Performing Assets" and "- Other Classified Assets" for a discussion of certain of the Bank's assets which have been classified as substandard and regulatory classification standards generally.
When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower and requesting payment. Contact is generally made after the expiration of the grace period (usually fifteen days) in the form of telephone calls and/or correspondence. In most cases, deficiencies are cured promptly. If the delinquency increases, the Bank will initiate foreclosure actions or legal collection actions if a borrower fails to enter into satisfactory repayment arrangements. Such actions generally commence at sixty to ninety days of delinquency.
Loans are placed on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. As a matter of policy, the Bank generally does not accrue interest on loans past due 90 days or more. See Note 2 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof.
Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. Real estate owned is initially recorded at the lower of fair value less estimated costs to sell the property, or cost (generally the balance of the loan on the property at the date of acquisition). After the date of acquisition, all costs incurred in maintaining the property are expensed and costs incurred for the improvement or development of such property are capitalized up to the extent of their net realizable value.
Under accounting principles generally accepted in the United States of America ("GAAP"), the Bank is required to account for certain loan modifications or restructurings as "troubled debt restructurings" under SFAS No. 15. In general, the modification or restructuring of a debt constitutes a troubled debt restructuring if the Bank, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower that the Bank would not otherwise consider under current market conditions. Debt restructuring or loan modifications for a borrower do not necessarily always constitute troubled debt restructuring, however, and troubled debt restructuring does not necessarily result in non-accrual loans.
Delinquent Loans. The following table sets forth information concerning delinquent loans at the dates indicated, in dollar amounts and as a percentage of each category of the Bank's loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans, rather than the actual payment amounts which are past due.
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Non-performing Assets. The following table sets forth the amounts and categories of the Bank's non-performing assets at the dates indicated.
---------- (1) Consists of one loan at September 30, 2005 which became real estate owned during fiscal 2006, one loan at September 30, 2003, and three loans at September 30, 2002 (all of which became real estate owned during fiscal 2003).
(2) Loans extended to the same borrower. The commercial business loan to the borrower was charged off in full in connection with the transfer to real estate owned of the property in 2006.
(3) Consists of one single-family residential construction loan at September 30, 2004.
(4) Consists of three credit card accounts at September 30, 2006, four loans at September 30, 2005 of which a $770,000 construction loan returned to current status subsequent to September 30, 2005, six loans at September 30, 2004, two loans at September 30, 2003, and one commercial real estate loan at September 30, 2002 which returned to current status subsequent to September 30, 2002.
(5) Includes loans receivable and loans held for sale, less construction and land loans in process and deferred loan origination fees and discounts.
The $189,000 of non-performing single-family residential loans at September 30, 2006 consisted of four loans with principal balances ranging from $4,000 to $114,000, with an average balance of approximately $47,300. Included within the four loans is one loan of $61,000 to a credit impaired borrower.
The $47,000 of non-performing home equity and lines of credit at September 30, 2006 consisted of one loan.
Loans 90 days or more past maturity which continued to make payments on a basis consistent with the original repayment schedule amounted to $0 and $770,000 at September 30, 2006 and 2005, respectively.
At September 30, 2006, the $2.4 million of real estate owned consisted of a commercial real estate property. During the second quarter of fiscal 2006, the Company transferred to real estate owned a restaurant located in Chesapeake City, Maryland secured by a $3.3 million commercial real estate loan as a result of the Company taking possession of the property. The Company also had a $500,000 commercial business loan outstanding in connection with this loan relationship. As a result of the transfer of the property to real estate owned at its approximate fair value of $2.7 million and the charge-off of the commercial business loan, the Company charged off $1.1 million against the allowance for loan losses in the quarter ended March 31, 2006. The Company is actively marketing the property for sale but believes that, due to the unique nature of the property as a waterfront restaurant, it may take an extended period to sell the property. In addition, the Company anticipates that certain repairs and improvements will be necessary to improve the property's marketability, a significant portion of which will be capitalized. Management currently estimates the total of such costs to range between $500,000 and $700,000, a portion of which will be charged in the period incurred.
The increase in real estate owned was offset, in part, by the sale of a residential home residing on the commercial property which was carried at a value of $250,000 and resulted in a pre-tax gain of $20,000. In addition, during the second quarter of fiscal 2006, a commercial property in which the Company held a 25% participation interest in a golf facility was sold with a carrying value of $760,000 resulted in a pre-tax gain of $158,000.
Other Classified Assets. Federal banking regulations require that each insured savings association classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. There are four classifications for problem assets: "substandard," "doubtful," "loss" and "special mention." Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted.
In connection with the recent OTS examination, the Company reviewed its asset classifications resulting in a substantial increase in its criticized and classified assets. At September 30, 2006, the Bank had $11.7 million of assets classified as substandard, no assets classified as either doubtful or loss, and $8.2 million identified as special mention. A substantial majority of the assets classified as substandard consists of commercial business and commercial real estate loans.
Allowance for Loan Losses. The Bank's policy is to establish reserves for estimated losses on delinquent loans when it determines that losses are probable. The allowance for losses on loans is maintained at a level believed by management to cover all known and inherent losses in its loan portfolio. Management's analysis of the adequacy of the allowance is based on an evaluation of the loan portfolio, past loss experience, current economic conditions, volume, growth and composition of the portfolio, and other relevant factors. The allowance is increased by provisions for loan losses which are charged against income. However, in fiscal 2006, the level of allowance for loan losses increased due to the Bank's evaluation of its estimate including, among other things, implementation of refinements to its rating system, an analysis of delinquency trends, non-performing loan trends, the levels of charge-offs and recoveries, the increased levels of classified and special mention assets, prior loss experience, total loans outstanding, the volume of loan originations in commercial real estate and business loans, the type, average size, terms and geographic location and concentration of loans held by the Company, the value and the nature of the collateral securing loans, the number of loans requiring heightened management oversight, general economic conditions, particularly as they relate to the Company's primary market area, trends in market rates of interest as well as extensive discussions with the OTS examination staff in connection with the examination. The Company's primary banking regulator periodically reviews the Company's allowance for loan losses as an integral part of the examination. As shown in the table below, at September 30, 2006, the Bank's allowance for loan losses amounted to 1,215.6% and 1.0 % of the Bank's non-performing loans and gross loans receivable, respectively.
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Management of the Company presently believes that its allowance for loan losses is adequate to cover all known and inherent losses that are both probable and reasonably estimable in the Bank's loan portfolio. However, future adjustments to this allowance may be necessary, and the Company's results of operations could be adversely affected if circumstances differ substantially from the assumptions used by management in making its determinations in this regard. The following table provides information regarding the changes in the allowance for loan losses and other selected statistics for the periods presented.
---------- (1) The charge-off in multi-family and commercial loans as well as a $500,000 charge-off in consumer and commercial business loans was related to the commercial property transferred to real estate owned discussed above.
(2) Gross loans receivable and average loans outstanding include loans receivable as well as loans held for sale, less construction and land loans in process and deferred loan origination fees and discounts.
The following table presents the Bank's allocation of the allowance for loan losses to the total amount of loans in each category listed at the dates indicated:
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MORTGAGE-RELATED AND INVESTMENT SECURITIES
Mortgage-Related Securities. Federally chartered savings institutions have authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies and of state and municipal governments, certificates of deposit at federally insured banks and savings associations, certain bankers' acceptances and federal funds. Subject to various restrictions, federally chartered savings institutions also may invest a portion of their assets in commercial paper, corporate debt securities and mutual funds, the assets of which conform to the investments that federally chartered savings institutions are otherwise authorized to make directly.
The Bank maintains a significant portfolio of mortgage-related securities (including mortgage-backed securities and collateralized mortgage obligations ("CMOs") as a means of investing in housing-related mortgage instruments without the costs associated with originating mortgage loans for portfolio retention and with limited credit risk of default which arises in holding a portfolio of loans to maturity. Mortgage-backed securities (which also are known as mortgage participation certificates or pass-through certificates) represent a participation interest in a pool of single-family or multi-family residential mortgages. The principal and interest payments on mortgage-backed securities are passed from the mortgage originators, as servicer, through intermediaries (generally U.S. Government agencies and government-sponsored enterprises) that pool and repackage the participation interests in the form of securities, to investors such as the Bank. Such U.S. Government agencies and government-sponsored enterprises, which guarantee the payment of principal and interest to investors, primarily include FHLMC, FNMA and the Government National Mortgage Association ("GNMA"). The Bank also invests in certain privately issued, credit enhanced mortgage-related securities rated AAA by national securities rating agencies.
FHLMC is a public corporation chartered by the U.S. Government. FHLMC issues participation certificates backed principally by conventional mortgage loans. FHLMC guarantees the timely payment of interest and the ultimate return of principal on participation certificates. FNMA is a private corporation chartered by the U.S. Congress with a mandate to establish a secondary market for mortgage loans. FNMA guarantees the timely payment of principal and interest on FNMA securities. FHLMC and FNMA securities are not backed by the full faith and credit of the United States, but because FHLMC and FNMA are U.S. Government-sponsored enterprises, these securities are considered to be among the highest quality investments with minimal credit risks. GNMA is a government agency within the Department of Housing and Urban Development which is intended to help finance government-assisted housing programs. GNMA securities are backed by Federal Housing Administration ("FHA") insured and the Department of Veterans Affairs ("VA") guaranteed loans, and the timely payment of principal and interest on GNMA securities are guaranteed by the GNMA and backed by the full faith and credit of the U.S. Government. Because FHLMC, FNMA and GNMA were established to provide support for low- and middle-income housing, there are limits to the maximum size of loans that qualify for these programs which is currently $417,000 (for single-family dwellings).
Mortgage-related securities typically are issued with stated principal amounts, and the securities are backed by pools of mortgages that have loans with interest rates that are within a range and have varying maturities. The underlying pool of mortgages can be composed of either fixed-rate or adjustable-rate loans. As a result, the risk characteristics of the underlying pool of mortgages (i.e., fixed-rate or adjustable rate) as well as prepayment risk, are passed on to the certificate holder. Thus, the life of a mortgage-backed pass-through security approximates the life of the underlying mortgages.
The Bank's mortgage-related securities include regular interests in CMOs. CMOs were developed in response to investor concerns regarding the uncertainty of cash flows associated with the prepayment option of the underlying mortgagor and are typically issued by governmental agencies, governmental sponsored enterprises and special purpose entities, such as trusts, corporations or partnerships, established by financial institutions or other similar institutions. A CMO can be (but is not required to be) collateralized by loans or securities which are insured or guaranteed by FNMA, FHLMC or the GNMA. In contrast to pass-through mortgage-related securities, in which cash flow is received pro rata by all security holders, the cash flow from the mortgages underlying a CMO is segmented and paid in accordance with a predetermined priority to investors holding various CMO classes. By allocating the principal and interest cash flows from the underlying collateral among the separate CMO classes, different classes of bonds are created, each with its own stated maturity, estimated average life, coupon rate and prepayment characteristics.
The short-term classes of a CMO usually carry a lower coupon rate than the longer term classes and, therefore, the interest differential cash flow on a residual interest is greatest in the early years of the CMO. As the early coupon classes are extinguished, the residual income declines. Thus, the longer the lower coupon classes remain outstanding, the greater the cash flow accruing to CMO residuals. As interest rates decline, prepayments accelerate, the interest differential narrows, and the cash flow from the CMO declines. Conversely, as interest rates increase, prepayments decrease, generating a larger cash flow to residuals.
A senior-subordinated structure often is used with CMOs to provide credit enhancement for securities which are backed by collateral which is not guaranteed by FNMA, FHLMC or the GNMA. These structures divide mortgage pools into various risk classes: a senior class and one or more subordinated classes. The subordinated classes provide protection to the senior class. When cash flow is impaired, debt service goes first to the holders of senior classes. In addition, incoming cash flows also may go into a reserve fund to meet any future shortfalls of cash flow to holders of senior classes. The holders of subordinated classes may not receive any funds until the holders of senior classes have been paid and, when appropriate, until a specified level of funds has been contributed to the reserve fund.
Mortgage-related securities generally bear yields which are less than those of the loans which underlie such securities because of their payment guarantees or credit enhancements which reduce credit risk to nominal levels. However, mortgage-related securities are more liquid than individual mortgage loans and may be used to collateralize certain obligations of the Bank. At September 30, 2006, $22.2 million of the Bank's mortgage-related securities were pledged to secure various obligations of the Bank, treasury tax and loan processing and as collateral for certain municipal deposits.
The Bank's mortgage-related securities are classified as either "held to maturity" or "available for sale" based upon the Bank's intent and ability to hold such securities to maturity at the time of purchase, in accordance with GAAP. As of September 30, 2006, the Bank had an aggregate of $108.4 million, or 13.4%, of total assets invested in mortgage-related securities, net, of which $38.4 million was held to maturity and $70.0 million was available for sale. The Company's investment strategy is to maintain the portfolio to complement the asset-liability structure of the Company. The Company's strategy during fiscal 2006 was to reinvest its cash flows into the loan portfolio as well as to assist the Bank in controlling its asset growth as required by the terms of the supervisory agreement. See "- Supervisory Agreements". The mortgage-related securities of the Bank which are held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts using a level yield method, while mortgage-related securities available for sale are carried at the current fair value. See Notes 2 and 4 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof.
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The following table sets forth the composition of the Bank's available for sale (at fair value) and held to maturity (at amortized cost) mortgage-related securities portfolios at the dates indicated.
---------- (1) Includes "AAA" rated securities of AMAC, Bank of America, Countrywide Home Loans, Credit Suisse First Boston, GSR, MastrAsset, Structured Asset Securities, Washington Mutual and Wells Fargo with book values of $3.6 million, $429,000, $2.6 million, $1.4 million, $1.2 million, $2.0 million, $604,000, $4.7 million and $7.5 million, respectively, and fair values of $3.5 million, $426,000, $2.5 million, $1.4 million, $1.2 million, $1.9 million, $602,000, $4.6 million and $7.3 million, respectively
(2) Includes "AAA" rated securities of AMAC, Credit Suisse First Boston, Countrywide Home Loans, First Horizon, GSR, MastrAsset, Washington Mutual and Wells Fargo with book values of $4.3 million, $1.7 million, $2.9 million, $4.4 million, $1.3 million, $3.1 million, $5.4 million, and $8.2 million, respectively, and fair values of $4.3 million, $1.6 million, $3.0 million, $4.3 million, $1.3 million, $3.1 million, $5.5 million, and $8.4 million, respectively.
(3) Includes "AAA" rated securities of Countrywide Home Loans, Washington Mutual, AMAC, First Horizon and Mastr Asset with book values of $5.2 million, $4.7 million, $2.0 million, $ 4.9 million and $4.0 million, respectively, and fair values of $5.2 million, $4.7 million, $1.9 million, $4.9 million and $4.1 million, respectively.
(4) See Note 4 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof.
The following table sets forth the purchases, sales and principal repayments of the Bank's mortgage-related securities for the periods indicated.
---------- (1) Includes both mortgage-related securities available for sale and held to maturity.
(2) Calculated at amortized cost for securities held to maturity and at fair value for securities available for sale.
At September 30, 2006, the estimated weighted average maturity of the Bank's fixed-rate mortgage-related securities was approximately 3.6 years. The actual maturity of a mortgage-backed security is generally less than its stated maturity due to prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and adversely affect its yield to maturity. The yield is based upon the interest income and the amortization of any premium or discount related to the mortgage-backed security. In accordance with GAAP, premiums and discounts are amortized over the estimated lives of the securities, which decrease and increase interest income, respectively. The prepayment assumptions used to determine the amortization period for premiums and discounts can significantly affect the yield of the mortgage-backed security, and these assumptions are reviewed periodically to reflect actual prepayments. Although prepayments of underlying mortgages depend on many factors, including the type of mortgages, the coupon rate, the age of mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates, the difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates generally is the most significant determinant of the rate of prepayments. During periods of declining mortgage interest rates, if the coupon rates of the underlying mortgages exceed the prevailing market interest rates offered for mortgage loans, refinancings generally increase and accelerate the prepayment rate of the underlying mortgages and the related securities. Conversely, during periods of increasing mortgage interest rates, if the coupon rates of the underlying mortgages are less than the prevailing market interest rates offered for mortgage loans, refinancings generally decrease and decrease the prepayment rate of the underlying mortgages and the related securities. During fiscal 2006 and 2005, the Company experienced lower prepayment speeds and refinancing activity as interest rates offered for mortgage loans in the marketplace increased during these time periods.
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Investment Securities. The following table sets forth information regarding the carrying and fair value of the Company's investment securities, both held to maturity and available for sale, at the dates indicated.
At September 30, 2006, the Company had an aggregate of $42.9 million, or 8.2 %, of its total assets invested in investment securities, of which $6.2 million consisted of FHLB stock, $33.4 million was investment securities available for sale and $3.3 million investment securities held to maturity. Included in U.S. Government and agency obligations is a callable bond with a remaining term of approximately six years. The Bank's investment securities (excluding mutual funds, equity securities and FHLB stock) had a weighted average maturity to the call date of 3.8 years and a weighted average yield of 5.38%.
SOURCES OF FUNDS
General. The Bank's principal source of funds for use in lending and for other general business purposes has traditionally come from deposits obtained through the Bank's branch offices. The Bank also derives funds from contractual payments and prepayments of outstanding loans and mortgage-related securities, from sales of loans, from maturing investment securities and from advances from the FHLBank Pittsburgh and other borrowings. Loan repayments are a relatively stable source of funds, while deposits inflows and outflows are significantly influenced by general interest rates and money market conditions. The Bank uses borrowings to supplement its deposits as a source of funds.
Deposits. The Bank's current deposit products include passbook accounts, NOW accounts, MMDAs, certificates of deposit ranging in terms from 30 days to five years and non-interest-bearing personal and business checking accounts. The Bank's deposit products also include Individual Retirement Account ("IRA") certificates and Keogh accounts.
The Bank's deposits are obtained primarily from residents in Delaware and Chester Counties in southeastern Pennsylvania. The Bank attracts local deposit accounts by offering a wide variety of accounts, competitive interest rates, and convenient branch office locations and service hours. The Bank utilizes traditional marketing methods to attract new customers and savings deposits, including print media, radio advertising and direct mailings. However, the Bank does not solicit funds through deposit brokers nor does it pay any brokerage fees if it accepts such deposits.
The Bank has been competitive in the types of accounts and interest rates it has offered on its deposit products but does not necessarily seek to match the highest rates paid by competing institutions. During fiscal 2006 and 2005, the Bank slightly increased deposits, primarily in certificate of deposits, due to competitively pricing its jumbo certificates of deposit causing a decline in its core deposits driven by the increases in short-term interest rates. Core deposits amounted to $172.9 million or 48.2% of the Bank's total deposits at September 30, 2006.
The following table shows the distribution of, and certain information relating to, the Bank's deposits by type of deposit as of the dates indicated.
The following table sets forth the net savings flows of the Bank during the periods indicated
The following table sets forth maturities of the Bank's certificates of deposit of $100,000 or more at September 30, 2006 and 2005 by time remaining to maturity (amounts in thousands).
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The following table presents, by various interest rate categories, the amount of certificates of deposit at September 30, 2006 and 2005 and the amounts at September 30, 2006 which mature during the periods indicated.
The following table presents the average balance of each deposit type and the average rate paid on each deposit type for the periods indicated.
Borrowings. The Bank may obtain advances from the FHLBank Pittsburgh upon the security of the common stock it owns in the FHLB and certain of its residential mortgage loans and securities held to maturity, provided certain standards related to creditworthiness have been met. Such advances are made pursuant to several credit programs, each of which has its own interest rate and range of maturities. At September 30, 2006, the Bank had $107.2 million in outstanding FHLB advances and overnight borrowings. The FHLB advances have certain call features whereby the FHLBank Pittsburgh can call the borrowings after the expiration of certain time frames. The time frames on the callable borrowings are within 12 months. Note 9 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof.
The following table sets forth certain information regarding the Bank's FHLB advances for the periods indicated.
In addition, the Company participated in junior subordinated debentures aggregating $21.5 million at September 30, 2006 held by statutory trusts that issued trust preferred securities comprising of $13.5 million in fixed-rate preferred securities and $8.0 million in floating-rate preferred securities. With the receipt of net proceeds from the private placement offering, the Company intends to redeem a significant portion of the floating-rate preferred securities. Due to the timing of this offering, the Company will not be able to partially redeem these preferred securities before June 8, 2007. See Note 16 of the Notes to Consolidated Financial Statements set forth in Item 8 hereof.
SUBSIDIARIES
The Bank is permitted to invest up to 2% of its assets in the capital stock of, or secured or unsecured loans to, service corporations, with an additional investment of 1% of assets when such additional investment is utilized primarily for community development purposes. It may invest essentially unlimited amounts in subsidiaries deemed operating subsidiaries that can only engage in activities that the Bank is permitted to engage in. Under such limitations, as of September 30, 2006, the Bank was authorized to invest up to approximately $10.5 million in the stock of, or loans to, service corporations. As of September 30, 2006, the net book value of the Bank's investment in stock, unsecured loans, and conforming loans to its service corporations was $65,000.
At September 30, 2006, in addition to the Bank, the Company has four indirect active subsidiaries: FKF Management Corp., Inc., State Street Services Corp., First Chester Services, Inc., and First Pointe, Inc.
FKF Management Corp., Inc., a Delaware corporation, is a wholly owned operating subsidiary of the Bank established in 1997 for the purpose of managing certain assets of the Bank. Assets under management totaled $159.3 million at September 30, 2006 and were comprised principally of investment and mortgage-related securities.
State Street Services Corp. is a wholly owned subsidiary of the Bank established in 1999 for the purpose of offering a full array of insurance products through its ownership of a 51% interest in First Keystone Insurance Services, LLC ("First Keystone Insurance"). First Keystone Insurance's financial data is consolidated into the Company's financial statements. Total assets for First Keystone Insurance were $134,000 and $280,000 at September 30, 2006 and 2005, respectively. Total liabilities for First Keystone Insurance were $32,000 and $248,000 at September 30, 2006 and 2005, respectively. Net income for the years ending September 30, 2006 and 2005 was $69,000 and $53,000, respectively.
First Chester Services, Inc. and First Pointe, Inc. are wholly owned subsidiaries which were reactivated to manage a real estate owned parcel and other assets related to the real estate owned parcel.
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EMPLOYEES
The Bank had 104 full-time employees and 24 part-time employees as of September 30, 2006. None of these employees is represented by a collective bargaining agreement. The Bank believes that it enjoys excellent relations with its personnel.
REGULATION
General. Set forth below is a brief description of certain laws and regulations, which are applicable to the Company and the Bank. The description of these laws and regulations, as well as descriptions of laws and regulations contained elsewhere herein, do not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
The Company. The Company as a savings and loan holding company within the meaning of the Home Owners' Loan Act, as amended ("HOLA"), is registered as such with the OTS and is subject to OTS regulations, examination, supervision and reporting requirements. As a subsidiary of a savings and loan holding company, the Bank is subject to certain restrictions in its dealings with the Company and affiliates thereof.
Federal Activities Restrictions. The Company operates as a unitary savings and loan holding company. Generally, there are only limited restrictions on the activities of a unitary savings and loan holding company which applied to become or was a unitary saving and loan holding company prior to May 4, 1999 and its non-savings institution subsidiaries. Under the Gramm-Leach-Bliley Act of 1999 (the "GLBA"), companies which apply to the OTS to become unitary savings and loan holding companies are restricted to only engaging in those activities traditionally permitted to multiple saving and loan holding companies. However, if the Director of the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings association, the Director may impose such restrictions as deemed necessary to address such risk, including limiting (i) payment of dividends by the savings association; (ii) transactions between the savings association and its affiliates; and (iii) any activities of the savings association that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings association. Notwithstanding the above rules regarding permissible business activities of grandfathered unitary savings and loan holding companies under the GLBA (such as the Company), if the savings association subsidiary of such a holding company fails to meet the Qualified Thrift Lender ("QTL") test, then such unitary holding company also shall become subject to the activities restrictions applicable to multiple savings and loan holding companies and, unless the savings association qualifies as a QTL within one year thereafter, shall register as, and become subject to the restrictions applicable to, a bank holding company.
If the Company were to acquire control of another savings association, other than through merger or other business combination with the Bank, the Company would thereupon become a multiple savings and loan holding company and would thereafter be subject to further restrictions on its activities.
The GLBA also imposes financial privacy obligations and reporting requirements on all financial institutions. The privacy regulations require, among other things, that financial institutions establish privacy policies and disclose such policies to its customers at the commencement of a customer relationship and annually thereafter. In addition, financial institutions are required to permit customers to opt out of the financial institution's disclosure of the customer's financial information to non-affiliated third parties.
The HOLA requires every savings institution subsidiary of a savings and loan holding company to give the OTS at least 30 days' advance notice of any proposed dividends to be made on its guarantee, permanent or other nonwithdrawable stock, or else such capital distribution will be invalid. See "- The Bank - Capital Distributions."
Limitations on Transactions with Affiliates. Transactions between savings associations and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act ("FRA") and OTS regulations issued in connection therewith. Affiliates of a savings institution include, among other entities, the savings institution's holding company and companies that are controlled by or under common control with the savings institution. Generally, Sections 23A and 23B (i) limit the extent to which the savings association or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such association's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the association or subsidiary as those
provided to a non-affiliate. The term "covered transaction" includes, among other things, the making of loans or extension of credit to an affiliate, purchase of assets, issuance of a guarantee and similar transactions. In addition to the restrictions imposed by Sections 23A and 23B, under OTS regulations no savings association may (i) loan or otherwise extend credit to an affiliate, except for any affiliate which engages only in activities which are permissible for bank holding companies, (ii) a savings association may not purchase or invest in securities of an affiliate other than shares of a subsidiary; (iii) a savings association and its subsidiaries may not purchase a low-quality asset from an affiliate; (iv) and covered transactions and certain other transactions between a savings association or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices. With certain exceptions, each extension of credit by a savings association to an affiliate must be secured by collateral with a market value ranging from 100% to 130% (depending on the type of collateral) of the amount of the loan or extension of credit.
OTS regulations generally exclude all non-bank and non-savings association subsidiaries of savings associations from treatment as affiliates, except to the extent that the OTS or the Federal Reserve Board ("FRB") decides to treat such subsidiaries as affiliates. The regulations also require savings associations to make and retain records that reflect affiliate transactions in reasonable detail, and provide that certain classes of savings associations may be required to give the OTS prior notice of affiliate transactions.
Restrictions on Acquisitions. Except under limited circumstances, savings and loan holding companies are prohibited from acquiring, without prior approval of the Director of the OTS, (i) control of any other savings association or savings and loan holding company or substantially all of the assets thereof; (ii) more than 5% of the voting shares of a savings association or holding company thereof which is not a subsidiary; (iii) acquiring through a merger, consolidation or purchase of assets of another savings institution (or holding company thereof) or acquiring all or substantially all of the assets of another savings institution (or holding company thereof) without prior OTS approval; or (iv) acquiring control of an uninsured institution except with the pri